Recessions uncover what auditors do not

In China, unprecedented times are bringing forth revelations on an unprecedented scale [link, link]. Some of the rackets that are described in China appear quite familiar to us in India, but the magnitudes seen there are astonishingly large. We had such problems in developed markets also — Madoff and MF Global.

Institutional reform: Consumer protection

One part of addressing this problem is the familiar machinery of the Indian Financial Code (IFC) version 1.1. As an example, see this analysis of ponzi schemes. As an IFC quality law is not found in either China or India, we have a rash of such problems in both countries.

Institutional reform: Criminal justice system

An important subset of financial crime is about plain criminal law. While the main track of financial policy has been along the Indian Financial Code, we need to develop a work program on improvements of the criminal justice system also. Put together, these will create an enforcement machinery that will generate deterrence against big financial scandals.

Procyclicality of trust?

Watching China unfold in recent weeks, I wonder if there’s a general proposition of the following nature. Recessions will uncover what auditors could not, but under conditions of low institutional quality, this will happen on a bigger scale. Conversely, when institutional quality is low, business and finance will be hampered at all times by low trust. But in good times, when it’s easier for the crooks to keep things under wraps, fewer scandals will burst into the public consciousness, and trust will go up. Procyclicality of trust may be heightened in places with low institutional quality.